AutoZone F4Q07 (Qtr End 8/25/07) Earnings Call Transcript

| About: AutoZone, Inc (AZO)
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AutoZone, Inc. (NYSE:AZO) F4Q07 Earnings Call September 18, 2007 10:00 AM ET

TRANSCRIPT SPONSOR
Wall Street Breakfast

Executives

Bill Rhodes - President & CEO

Bill Giles - CFO

Analysts

John Lawrence - Morgan Keegan

Robert Higginbotham - Goldman Sachs

Dan Wewer - Raymond James

Adam Timler - Deutsche Bank

Irene for Danielle Fox - Merrill Lynch

Peter Benedict - Wachovia

Tony Cristello - BB&T Capital Markets

Seth Basham - Credit Suisse

Operator

Welcome and thank you for standing by. This is the conference call to discuss AutoZone's fourth quarter financial results. Bill Rhodes, the Company's President and CEO will be making a short presentation on the highlights of the quarter. (Operator Instructions) Before Mr. Rhodes begins, the company has requested that you listen to the following statement regarding forward-looking statements.

Certain statements contained in this presentation are forward-looking statements. Forward-looking statements typically use words such as believe, anticipate, should, intend, plan, will, expect, estimate, project, position, strategy, and similar expressions. These are based on assumptions and assessments made by our management in light of experience and perception of historical trends, current conditions, expected future development says and other factors we believe appropriate.

These forward-looking statements are subject to a number of risks and uncertainties including, without limitation, competition, product demand, the economy, credit markets, the ability to hire and retain qualified employees, consumer debt levels, inflation, weather, raw material costs of our suppliers, energy prices, war and the prospect of war including terrorist activity, availability of consumer transportation, construction delays, access to available and feasible financing, and changes in laws or regulations.

Forward-looking statements are not guarantees of future performance and actual results and developments in our business may differ from those contemplated by such forward-looking statements, and such events could materially and adversely affect our business. Forward-looking statements speak only as of the date made. Except as required by applicable law, we undertake no obligation to update publicly any forward-looking statements whether as a result of new information, future events, or otherwise. Actual results may materially differ from anticipated results. Please refer to the risk factor section of AutoZone's Form 10-K for the fiscal year ended August 26, 2006 for more information related to those risks.

In addition to the financial statements presented in accordance with Generally Accepted Accounting Principles, AutoZone has provided metrics in this presentation that are not calculated in accordance of GAAP. For a reconciliation of these metrics please see AutoZone's press release in the Investor Relations section at www.autozoneinc.com.

Mr. Rhodes, you may now begin.

Bill Rhodes

Good morning. Thank you for joining us today for AutoZone's fiscal 2007 fourth quarter conference call. With me today are Bill Giles, Executive Vice President and Chief Financial Officer, Store Development and IT; and Brian Campbell, Vice President, Treasurer, Investor Relations and Tax.

Regarding the fourth quarter, I hope you had an opportunity to read our press release and learn about the quarter's results. If not, the press release along with slides complementing our comments today, is available on our website, www.AutoZoneInc.com. Please click on quarterly earnings conference calls to see them.

To begin, I would like to thank our entire organization, all 54,000 AutoZoners for their incredible efforts in completing another year of record earnings. We accomplished more than simply earnings however, as we made significant progress on each of our initiatives, which has positioned us well as we begin fiscal 2008. We dissected and then rebuilt our merchandise assortment process. We reinvigorated our commercial organization with expanded parts coverage and enhanced our team sales processes in order to profitably grow sales; and most importantly, our customer service levels have continued to make steady improvement year over year.

In fact, I would like to spend a moment talking about a little history. A little over two years ago, we were experiencing significant sales declines and had just completed extensive customer research that revealed our customers' level of satisfaction with their AutoZone experience was declining. Our leadership team soon afterward determined it was essential to make significant changes to our actions. We embarked on major initiatives, including resetting virtually our entire domestic store base -- over 3,200 stores at the time -- in order to allow our customers the ability to navigate our sales floor more effectively and find the merchandise they needed. We accomplished that feat on time and for a fraction of our initial estimates.

We also invested and continued to invest today in more training for our AutoZoners. We completed line reviews on all of our merchandise categories -- no small feat -- and we invested in technology to improve our service levels. While that had some short-term negative impact on earnings growth in fiscal 2006, it positioned us appropriately for the future.

Most importantly, our research shows us it continued to improve the customer shopping experience while raising the confidence level and morale of our AutoZoners. Fiscal 2007, as we discussed, has been a continuation of that store based customer focus. It has been a year of living our pledge. The pledge keeps us razor focused when addressing our major operational and strategic questions.

One of the challenges we faced early on in fiscal 2007 was the enhancement of our hard parts assortment. While I use the word enhancement, it was more of a complete reinvention of how we look at merchandise needs to be added and subtracted to our stores, on a store-by-store basis. It took us through the third quarter of this year to implement the majority of these changes. While we were successful at balancing our parts needs with the always prevalent risk of increasing inventory, our additions in fact represented the largest new parts addition this decade. We added approximately $70 million in additional inventory, mainly late model hard parts in order to say yes to our customers.

So fast-forward to this morning. Today we will update you on our financial results for the quarter, but we are also going to tell you why we are excited to begin our new year. Our stores do look great. Our customers are telling us their intent to return is as high as ever, based on our survey results and our commercial business really feels like it is beginning to build momentum for future profitable sales growth.

We know our customers on the retail side shop with us on average three or four times a year. Therefore, we expect that it will take time for each of our initiatives to resonate with them. However, we know we are in a better position to say yes more than we have been able to in some time, and we believe in fiscal 2008 we can increase our ability to say yes to our customers even more.

Lastly I would like to mention the stability of our business model. While our same-store sales were generally flat, we were definitely impacted by regional impediments. At the same time, we're not immune to short-term macro impacts on sales from weather to gas prices to consumer credit challenges. However -- and most importantly -- through all of these factors, we continued to deliver solid earnings growth.

Finally, I want to point out that tomorrow morning we are hosting here in Memphis all our field management at our national sales meeting. My opening comments will be centered on congratulating our team on a solid year and the importance of continuing and in fact increasing our focus on our customers. We are well-positioned to capture market share in fiscal 2008 based on the successful rollout of our initiatives over the past 12 months. We have the tools to be successful. We've got great field leadership to shepherd our messages, lead by example, and provide the support and guidance our AutoZoners need and deserve, and we have a vastly improved parts assortment to offer, especially to our commercial customers.

For the agenda this morning I will review our overall financial results, including detail regarding our DIY sales initiatives, commercial selling initiatives and Mexico. Bill Giles will then provide more detail on our earnings performance as well as provide an overview of both our balance sheet and cash flow statements for this past quarter. Finally, I will provide a few closing comments before we proceed to questions.

Now turning to Q4, regarding the fourth quarter, for the 16 weeks ended August 25th, we reported sales of $2.003 billion, an increase of 3.3% from last year's fourth quarter. Same-store sales, or sales for stores open more than one year, were down 0.2% for the quarter. While we were not immune to regional and macro challenges, we were pleased with several of our underlying metrics that showed customers recognized what we are doing inside our stores to improve the shopping experience, and their inclination to shop with us in the future continued to increase.

The fourth quarter for us began back on May 6th, and the average price of gasoline nationally was $3.10. By the end of the quarter, the price had settled back to $2.75. We have now become used to these gyrations in pricing and we believe our customers are getting used to the fluctuations as well. The current prices at the pump are slightly ahead of last year's prices at this time. Historically, unleaded gasoline pricing softens heading into the winter months, as miles driven declines. We believe we can continue to do things with both our merchandise and marketing efforts to provide value for our customers during times of high gas prices.

In the fourth quarter, gross profit as a percentage of sales was up 50 basis points versus last year's quarter, while operating expenses as a percentage of sales increased by 85 basis points. This resulted in an operating margin of 18.9%, down 35 basis points from last year's quarter. Operating profit increased 1.4% versus the prior year. Net income for the quarter was $217 million, and diluted earnings per share increased 10.6% to $3.23 from $2.92 in the year-ago quarter.

Our continued disciplined capital management approach resulted in return on invested capital for the trailing four quarters of 22.7%. While effectively flat with last quarter, we've shown a solid improvement over the previous year. Return on invested capital is a key measure of our success. We have made and will continue to make investments that generate returns that significantly exceed our cost of capital. We will not deviate from our efforts to optimized shareholder value over the long term. We continue to be fiscally prudent with our investments while optimizing our earnings per share.

Total domestic retail sales were up 2.7% for the quarter. During the fourth quarter, we continued to focus on driving sales and profits for the long term. I would like to speak individually to the major initiatives we have established for our organization to drive both retail and commercial sales for fiscal 2007 and beyond.

For us, our focus continues to be about our customers and their interactions with our AutoZoners. We demand that our AutoZoners always put our customers first. For that reason, we continue to challenge our AutoZoners to make sure they're living the pledge. As I mentioned earlier, we have and will continue to focus our sales efforts on improving the customer's shopping experience. During the fourth quarter, we marketed our Z-net software across both television and radio to educate our customers on what we believe is the absolute best parts lookup system and support tool for DIYers in the entire industry. Our feedback was exceptional from both AutoZoners and customers. Enhancing Z-net will continue to be a major focus for us in the future.

We continued our WITTDTJR meetings, with our entire field organization, an acronym for What It Takes To Do the Job Right. These focus on educating our AutoZoners on how to serve our customers better. During the fourth quarter, our Shift to Win program was centered on reviewing with each customer the features and benefits of our products so that they can select the right product for the job. This effort will continue for fiscal 2008.

We change millions of wiper blades, batteries, headlights, and even help diagnose possible engine problems every year, but we have struggled to answer the simple question, how often are we satisfying our customers? Over the last couple of years, we decided to leverage our customer relationships and constantly ask them for their feedback on our opportunities for improvement. Surprisingly, we learned just 70% of the time our customers were able to find what they needed. While this metric was up considerably based upon several historic studies, it was clear there was, and still is, significant room for improvement. Ironically, while they said we could improve our assortment to fit their needs, they continued to tell us they have never have been more satisfied with our service and their intent to return is currently at an all-time high.

So for 2008, we are focused on improving these important measurements even more. From continuing to challenge all of our AutoZoners to become ASE certified -- and there are more today than ever before -- to improving the shopability of our stores through continue refreshes. For instance, we painted over 800 stores this year, and resurfaced more parking lots in our stores than in many years. Finally, the continual refinement of our off-shelf merchandise placements to offer more of what our customers are demanding. We also continue to utilize our loyalty program to learn more about our customers than ever before. Although still very early, this has begun to help us dissect buying habits of our shoppers.

Lastly I would like to mention that our belief is we have gained market share within our industry. Through the use of NPD data, we're learning both our sales floor and application parts businesses are beginning to grow share. While we believe we're in the early stages, our customers are more and more satisfied with their AutoZone shopping experience.

Quickly, I would also like to discuss our advertising focus for 2008. We will continue to utilize television and radio advertisements with radio still the dominant medium. We will continue to focus our messaging on trustworthy advice provided by our AutoZoners every day, and also on building both the AutoZone and Duralast brands.

A second major focus for this year continues to be around our hard parts product assortment. This has been a major focus throughout the year, and will continue to be a major focus for us in 2008. Everyone across our company is excited about the hard parts additions we have made, and we've begun to see successes in several key categories where we've placed specific emphasis. We know our ability to say yes to customers is what drives sales. Customers do shop competition. In today's environment, a retailer has to have the right assortment, and knowledgeable sales associates or you'll risk lowering your competitive edge with consumers.

While inventory levels per store in total were essentially flat with last year at $500,000 per store, the new additions we added have been significant. Many of these additions were late-model coverage, and we know these parts will help both our commercial and retail customers.

As part of reviewing our hard parts assortment, our merchandise organization has done a good job of rationalizing our SKU assortment which has allowed us to add new SKUs while maintaining inventory levels. This effort around parts additions will continue in 2008. I would be remiss here if we didn't thank our entire merchandising, distribution and field organizations for their efforts this past year on making sure our assortment meets our customers' demands.

Additionally, we will continue to grow our brand recognition in the marketplace through our proprietary brand initiatives. We believe these products, many of which bear the Duralast name, continue to offer another key point of differentiation for us and provide great value to our customers.

Finally, our direct import initiative continues to gain traction. We still have a very small amount of our products that are imported directly, but we have been very pleased with our progress to-date. This will continue to be an important initiative for us for many years to come.

Regarding macro trends, during the fourth quarter as I said earlier, gas prices started out very high, but declined to last year's levels at $2.75 a gallon for the week ending August 25th. Obviously, we cannot control the prices of gas at the pump. We certainly feel with more cars on the road than ever before, our ability to grow sales remains strong over the long run, and consumers will ultimately adjust their spending habits for the higher prices. We will continue to develop marketing programs that support our customers' needs during these high-priced times.

Regarding miles driven, we saw an increase in miles driven in May. However, there was a decrease in June. July and August are not yet available. Let me reiterate the two statistics we always felt have the closest correlation to our market growth over the long-term: miles driven and the number of seven-year-old and older vehicles on the road. While miles driven have been challenged recently, there are more registered vehicles on the road today than in our country's history.

For the quarter, we estimate that weather had no real net impact on our sales. As June and July temperatures were unseasonably mild across a majority of the country, August was warmer. As we have often said, we are in charge of our own results, and the impact of weather and gas prices don't impact us over the long term.

Regarding pricing across the industry, we have not seen any material change in the competitive landscape. Overall, consumer price inflation in Q3 remained in the low single-digit range. For the trailing four quarters, sales per square foot were $239. This statistic continues to set the pace for the rest of the industry.

Now let's move to commercial. For the quarter, total commercial sales posted an increase of 0.5% from last year's quarter. We now have the commercial program in 2,182 stores supported by 133 hub stores. While not up to our aspirations, we believe this represents a clear improvement. We were pleased with our progress in this business during the fourth quarter. Our commercial team put together a very solid marketing campaign to communicate our hard parts enhancements, and our results are beginning to resonate with both our current customers and potential new ones. Our test stores continue to perform well. However, all our commercial programs showed promise during the quarter.

Now that we have improved our parts coverage supported by updated marketing materials, we are increasing our focus on establishing a more sales-oriented culture. Our commercial leadership is focusing diligently on both smaller up and down the street accounts as well as larger chain accounts to profitably grow our sales. There have been significant transformational improvements happening in our commercial business, and none more important than the profitability we are enjoying. While we do not break out this business' profitability – [inaudible]

This is Bill Rhodes again. I apologize for that. Somehow we got disconnected. I am going to start back at the beginning of our comments on commercial sales. For the quarter, total commercial sales posted an increase of 0.5% from last year's quarter. We now have the commercial program in 2,182 stores, supported by 133 hub stores. While not up to our aspirations, we believe this represents a clear improvement. We are pleased with our progress in this business during the fourth quarter. Our commercial team put together a very solid marketing campaign to communicate our hard parts enhancements and our results are beginning to resonate with both our current customers and potential new ones. Our test stores continue to perform well. However, all our commercial programs showed promise in the quarter.

Now that we have improved our parts coverage supported by updated marketing materials, we are increasing our focus on establishing a more sales-oriented culture. Our commercial leadership is focusing diligently on both the smaller up and down the street accounts as well as the larger chain accounts to grow sales. There have been significant transformational improvements happening in our commercial business, none more important than the profitability we're enjoying. While we do not break out this business's profitability, I would like to state its operating income continues to perform better than last year. Additionally, we feel with the learnings from our test stores we continue to perform very well. We have a lot to be encouraged about.

We believe we are making good progress in this area, but substantial opportunities still exist. That is why we continue to be prudent with the expansion of our new programs and additions to our test program. We also remain focused on building on our heritage of leveraging technology to deliver exceptional service. This past year, we made material enhancements to our proprietary order management system and we're working diligently to utilize the Internet to further enhance our commercial business.

I also like to congratulate our commercial team for transitioning away from our formal supply chain agreement with Midas Corporation. This agreement ended early in the quarter, and we congratulate our team on transitioning away from that arrangement and effectively filling in the void left by the departure of that business. In addition, we're working diligently to continue to earn the Hot Shot business from the Midas franchisees.

Finally, we remain committed to building this business to win for the long run. We are not interested in driving short-term sales results at the expense of profits. We believe all the items we have been discussing are building momentum. Each of these pieces must work in a cohesive manner for us to not only attract but maintain our commercial customers.

Let us turn briefly to Mexico. Our Mexico stores continued to perform well. We opened 13 new stores during the fourth quarter and for the year we opened 23 new stores. We currently have 123 stores in Mexico. Our ongoing commitment remains to prudently and profitably grow the Mexico business.

Now we'll turn it over to Bill Giles to take you through the remainder of the income statement, cash flows and the balance sheet.

Bill Giles

Thank you, Bill, and good morning, everyone. Let me begin with gross margin. Gross margin for the quarter was 50.1% of sales, up 50 basis points compared to last year's fourth quarter. In the fourth quarter, margins continued to benefit from our ongoing category management initiatives, import efforts, and leveraging supply chain efficiencies. Over the last several quarters, these efforts have been partially offset by an increase in product costs, specifically related to oil-based products.

We continue to be successful in working to offer the right products at the right prices to our customers. This includes supply chain initiatives, tailoring merchandise mix, and the continued optimization of our good, better, best product lines, all allowing us to price our products appropriately while giving our customers great value.

It is worth pointing out that we continue to see positive consumer response to our Duralast and Duralast Gold product lines. Our customers, both retail and commercial, continue to recognize the benefits from buying our better and best merchandise lines. Going forward, we believe there continues to be opportunity for gross margin expansion, albeit at reduced rates. Our direct import initiative is in its early stages, but we are pleased with the progress our merchandising organization has made with their abilities to improve margins while pressures procurement costs continue to exist.

SG&A for the quarter was 31.3% of sales, up 85 basis points from last year. Our deleverage came primarily from our inability this past quarter to leverage our fixed costs based on slightly negative comp sales performance. Specifically, rents and depreciation were 56 basis points higher than last year's fourth quarter.

At the same time, we continue to invest in additional marketing efforts and training programs for all AutoZoners in order to improve customer service. As I have mentioned before, the AutoZone culture of thrift and focus on cost management is essential to our ongoing business model. In fact, our SG&A per store, excluding occupancy, was lower than last year at this time. We believe our efforts on improving customer service implemented during the quarter will pay dividends into the future from a sales perspective. Over the long run, we continue to believe we can leverage operating expenses on a 1.5% to 2% same-store sales increase.

EBIT for the quarter was $378 million, up 1.4% over last year. Interest expense for the quarter was $38.1 million, compared with $34.9 million a year ago. Debt outstanding at the end of the quarter was $1.936 billion or approximately $78 million more than last year. The increase in interest expense reflects higher levels of debt as the ongoing effort to term out the company's debt on a long-term basis as well as the year-over-year increase in short-term rates. Additionally, interest was higher due to the accounting for capitalized leases established in the first quarter of this year. We expect interest expense to remain higher than the previous year heading into 2008.

Our adjusted debt levels were maintained inline with our target of 2.1 times our trailing 12-month EBITDAR. We have purposely managed our structure relative to our cash flow in order to maintain our credit ratings at investment grade while optimizing our cost of capital.

For the quarter, our tax rate was 36.2% below last year's rate of 36.9%. Net income for the quarter of $217 million was up 1.7% over the prior year. Earnings per share for the quarter of $3.23 were up 10.6% on 67.3 million average diluted shares.

I would like to take a moment here and remind everyone that our current fiscal year, fiscal 2008, has an extra week in it. Every six years or so our fiscal year has this 53rd week included in the fourth quarter, so at this time next year we'll be talking to you about EPS numbers with an extra week in them. We encourage everyone to model with this extra week taken into account. At the time of reporting, we will break out what the impact this extra week had on our business.

Related to the cash flow statement in the fourth quarter, we generated $361 million of operating cash flow, and we repurchased $297 million of AutoZone stock as part of our ongoing stock repurchase program. For the fourth quarter of this year, we reported an industry-leading ROIC of 22.7%. We're proud to report that this metric continues to improve over last year's already industry-leading rate.

Accounts payable as a percent of gross inventory finished the quarter at 93% compared to 92% last year. We continue to be committed to our goal of achieving 100% AP to inventory and we are pleased with our momentum. Inventory per store on the balance sheet plus the excluded pay on scan inventory was $500,000 versus Q4 of last year of $501,000. This quarter, we reported a total of $22 million of inventory on POS which in accordance with GAAP, is not reflected on our balance sheet. As we have stated previously, POS is about aligning the interests of AutoZone and our suppliers and it is one of the programs we use to achieve our financial goals.

Total working capital was a negative $15 million versus last year's balance of $64 million. We will continue to focus on minimizing working capital as this reflects our ongoing focus on increasing cash flow. Net fixed assets were up 6.2% versus last year. Capital expenditures for the quarter totaled $67 million and reflected the additional expenditures required to open 69 new stores this quarter, maintenance on existing stores, systems enhancements and work on development of new stores for upcoming quarters.

Specifically related to new store openings, our new stores are on track to achieve at least a 15% IRR, and we continue to see ample opportunity to open stores in the U.S. at a mid single-digit growth rate for the foreseeable future. We opened 53 new stores in the quarter for a total of 3,933 stores in 48 states, the District of Columbia and Puerto Rico. Our goal this year was to open stores more evenly throughout our fiscal year. We also relocated three stores this past quarter, and we continue to see opportunities to expand this initiative in the future. We also celebrated the opening of our 4,000th store in Houston, Texas, this past quarter. This is a wonderful milestone for everyone at AutoZone, and we celebrated this event across the entire company.

Depreciation totaled $51 million for the quarter, higher than last year due primarily to new stores, and the accounting for new capital leases established at the beginning of 2007. As of August 25, 2007, AutoZone continues to be one of the few players in our industry to have investment-grade debt ratings. Our senior unsecured debt rating from Standard & Poor's is triple B plus, and we have a commercial paper rating of A-2. Moody's investor service has assigned us a senior unsecured debt credit rating of PAA-2 and a commercial paper rating of P-2.

Now I will turn it back to Bill.

Bill Rhodes

Thank you, Bill. In summarizing AutoZone's fourth quarter results, I would first highlight our EPS growth of 11% over the prior year's fourth quarter. In an environment where we are seeing a more cautious consumer, the AutoZone model continues to prove itself capable of generating double-digit EPS growth. I think it is important to refer back to my opening comments. We've shown that we can generate double-digit EPS growth with relatively flat same-store sales results. While we are definitely not satisfied with this quarter's sales results, we believe the initiatives we've implemented in 2007 and those we plan for fiscal 2008 will lead to increased sales. With those sales, we're excited about what it can mean for EPS.

We are confident our model remains strong. We're convinced we have the correct strategy to succeed for the long run. We continue to feel of confident in our plan. We understand our success is built on doing the little things right to satisfy our customers. We believe our stores do look great, and our AutoZoners have better tools at their disposal than ever before.

However, I want to reiterate, our approach is about steady improvements over the long run. Our story continues to be one of steady, profitable sales improvement. We're about staying focused while making methodical improvements in the model so we will be well positioned for the future fiscal quarters and years. Our customer survey results tell us the AutoZone shopping experience continues to improve versus last year, and we're beginning to gain share in both our front of store and in the critically important hard parts area.

While we do not provide financial guidance, the entire AutoZone team continues to be enthusiastic about our future. We continue to feel confident in our long-range plans. Our plan is a simple one: to provide our customers the parts they want at the prices they demand with great service provided by AutoZoners who have a great place to work.

2008 will be about refining our parts assortment to further make sure the correct model coverage is available to all of our customers. It will about utilizing our hub store network to an even greater degree to make late model parts coverage more available to more of our stores than ever before. It will also be about optimizing inventory turns. It will be about growing our commercial business for sure.

Customer service will continue to be our key point of differentiation, and AutoZoners across the company are committed to providing that service to every customer. 2008 will be about making sure we place our customers first.

We continue to demonstrate industry-leading financial metrics and being a disciplined company, we have proven our ability to manage costs appropriately and invest in incremental initiatives that exceed our stated 15% after-tax IRR hurdle rate. We're focused on operating this company to profitably grow sales, efficiently deploy capital and optimized long-term shareholder value.

I thank you today for letting us share with you our company's past accomplishments and touch on our ongoing initiatives. We look forward to keeping you abreast of our results well into the future.

Now I would like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Lawrence - Morgan Keegan.

John Lawrence - Morgan Keegan

Good morning, guys. Bill, thanks for that detail on a lot of those initiatives. On the commercial side, would you dig just a little further there and talk a little bit about some of the tests, the transitioning with more profitability? How is that coming about? And, some examples of how the hard parts coverage is helping your business.

Bill Rhodes

John, I would start with we rolled out our test programs about a year ago, and we continue to roll them out, although at a very prudent place. We are functioning, as I said on the last call, in a pay as we go model. We're going to make sure the investments we're making are proving themselves. That's one of one of the beauties of having 4,000 locations and almost 2,200 commercial programs. We don't having to full steam ahead at any point in time so we can prove the activities we're doing are paying off.

We've been very encouraged, particularly on the commercial side with the product assortment improvements we've made over the last nine months, and we're now just beginning to really build a sales force, what we call a world-class sales culture, and that's something that's new to us. Historically we've been a retailer, and retailers don't have direct sales operations. We're continuing to learn in that area. Obviously we brought Larry Rozell in about six months ago, and he and his team are very focused on building a true world-class sales organization.

John Lawrence - Morgan Keegan

Secondly, Bill, can you give us on the SG&A line going forward, will some of those other initiatives as far as training and advertising continue to add to the expense line?

Bill Giles

I think overall that we wouldn't expect that kind of level of deleverage on an ongoing basis. We're very much committed to making sure we continue to invest in the initiatives to help drive and improve customer service on an ongoing basis, and I think that we have our expenses appropriately managed.

Operator

Our next question comes from Robert Higginbotham - Goldman Sachs.

Robert Higginbotham - Goldman Sachs

Can you give us a sense of how sales progressed through the quarter and also give us some extra color on what the regional disparities were? I am particularly interested in what Florida and California looked like.

Bill Giles

Robert, historically we do not break out sales trends throughout the quarter or even regionally. I can't say that we've necessarily seen anything that we would say that one particular region is carrying us or killing us necessarily. What we're doing is really focused on a lot of things across the organization. I think we have done a pretty good job throughout the year of improving and expanding our product assortment particularly on the hard parts side of the business. I think we've done a good job of continuing to improve our customer service levels. We get good feedback from our customers that our overall service levels and satisfaction levels have improved on a year-over-year basis. It is a lot of things throughout the quarter that actually helped us improve the momentum we have gained.

Robert Higginbotham - Goldman Sachs

Fair enough. In that case, could you comment on why you think that the DIY environment is still as tough as it is? You yourself commented how gas prices have tapered off a bit in terms of year-over-year increases, and I know miles driven are up and down each and every month, but you pointed to the OKDs being at historically high levels. What do you feel is out there that's really kind of depressing that side of the business and when do you think that really starts to turn around?

Bill Rhodes

I would start with, we haven't seen a radical material change in our DIY performance over the last 24 months, and certainly miles driven have flattened to slight declines over the last 18 months, but what we're focusing on is what can we do to make our business more productive? We have so many opportunities to continue to become more and more relevant to our customers. All these macro things we can't do anything about them, and so we're just very focused on, what can we do? We're very pleased with the progress we're making on our initiatives, but the bottom line is it hasn't generated the sales growth we want, need or expect. We're not significantly off from that, but we're not meeting our aspirations, and that's our commitment regardless of what's going on in the macro environment, we need to go meet our expectations.

Operator

Our next question comes from Dan Wewer - Raymond James.

Dan Wewer - Raymond James

Bill, just to follow up on the sales discussion, same-store sales have essentially been flat for the last four years, and recognizing that the industry slump in the last six quarters as worked against the company, you sound a lot more upbeat for '08. I recognize you're not providing any guidance, but is there anything tangible that you could show us to get us more upbeat about your top line growth in '08? I guess one item you alluded to was the customer surveys, but is there anything else you can point to?

Bill Rhodes

Dan, we continue to see progress in a lot of fronts. We've seen progress on the merchandise in specific categories where we've added merchandise, specific instances we've seen it work. Quite frankly we have seen that we have made mistakes with our new product assortment system well as well, and we're learning from those mistakes and will continue to learn from those mistakes.

We continue to see nice improvements in our customer service metrics, and this is the first time I believe in eight quarters or so where we've actually had a positive total commercial sales number. We said for the last couple of years we're working on building a model that drives to profitable, commercial growth. We finally have a slight positive, 0.5%, but that was also with a little bit of a head wind due to the Midas supply chain agreement termination. So we continue to believe we're working on the right things and that we're seeing progress. When we make changes, we can see progress from those changes. That's what encourages us.

Dan Wewer - Raymond James

If we do see a sales breakout in '08, it sounds like it will more than likely originate on the commercial side of the business, that's where you had the greatest opportunities. Is that accurate?

Bill Rhodes

I think clearly we have the greatest opportunity on commercial. We have 13% market share on DIY, 1.3% on commercial. We have a tremendous long-term opportunity in commercial and a tremendous long-term opportunity in DIY, but we have a more mature model in DIY than we do in commercial.

Dan Wewer - Raymond James

Finally, I believe you noted that you don't break out profitability between those two segments, but is it fair to say that we're seeing a better gross margin improvement in the commercial side of the business of late than we are in the do it yourself segment?

Bill Giles

I would say not necessarily, Dan. I think overall we're pleased with the gross margin improvement we've made. I think the merchandising organization has done a very good job of lowering our product acquisition costs using several measures including imports, so overall I think that we're getting good lift from that. I wouldn't necessarily pin it on one particular area versus another.

Operator

Our next question is from Adam Timler - Deutsche Bank.

Adam Timler - Deutsche Bank

First, I want to make sure I understood this correctly. Did you comment in your prepared remarks you will essentially able to offset the lost revenue from Midas with other initiatives in the quarter on the commercial side?

Bill Rhodes

That's correct. Overall our sales performance was up 0.5%, which as I just mentioned was the first time in three quarters or so it went positive, and that was despite the termination of the Midas agreement which formally terminated on July the 1st, but there was a transition that began around April 1st.

Adam Timler - Deutsche Bank

Then just to go back to your comments really for the first time now you've had a very good, almost world-class sales force on the commercial side. I guess when you talked about this business previously, really the focus was trying to move up the call list from the garages and then having the parts coverage. Would you re-rank those priorities now on the commercial side? Would you say that perhaps having a better sales force is more important than one of those or how do you look at the commercial business now?

Bill Rhodes

That's a great question, Adam. Let me clarify one thing. I didn't say we have a world-class sales force. We are working towards developing a world-class sales force. We have some great AutoZoners in those roles, but we have to help them with the processes and tools and training to become those great direct sales people.

To answer the other part of your question, what we focused on over the last 12 months is making sure we have the foundational elements in place to be successful in that business; make sure we have the parts we need in that business; make sure we have the people answering the phones and driving the trucks that are the right people; and making sure that we're delivering on our promise of 30-minute deliveries.

Once we do that and once we have that foundation in place, now it is to go out and tell that story, and back in around April we began a marketing campaign where once every couple of months we will go out with a sales flyer. We've done one on brakes. We've done one on air conditioning, one on rotating electric starters and alternators and one on engine management. These are great tools that help our sales people tell the AutoZone story. It talks about coverage. It talks about quality of parts, and those have really been some great tools that have added to it.

I wouldn't say it is more important to have a world-class sales organization. You've got to have the foundation in place first, but once you have that, then you can have a sales force go out and tell that story.

Adam Timler - Deutsche Bank

Very good. Lastly, something a little bit different topic, have you seen any impact per se from the fact that perhaps cars are changing their oil a little less frequently just due to improvements in the quality of the oil and how the cars run from a traffic standpoint at all?

Bill Rhodes

Clearly over an extended period of time the oil drain as we call it has been extended. Many of the car manufacturers today will tell you that you can change your oil every 7,500 miles or 10,000 miles, versus 3,000 miles which is the historical trend. However, you will read further in the owner's manual it says you can only do that if you're not considered a severe driver and severe driving is like driving around in Memphis, or driving in dust. The parameters on it are pretty light.

We've seen some lengthening in that, and certainly that's been part of our traffic challenges, but you also have things like synthetic oils which also, although they don't change them at frequently, they cost much more, so there is a natural lift in several categories where the average price of the parts is going up, but the change interval is decreasing.

Operator

We have a question from Danielle Fox of Merrill Lynch.

Irene for Danielle Fox - Merrill Lynch

I just have a quick question. Do you have an idea when inventory increases will be slower than sales increases? Is it fair to say by end of '08?

Bill Giles

The way I would look at it is our inventory overall is flat with last year and actually slightly lower, so we feel pretty good about some of the improvements that we've made on inventory management perspective. We don't necessarily project out guidance on a go-forward basis. What I would tell you is that I think we've done a pretty good job as an organization in adding some additional parts coverage, particularly in the hard parts side of the business, and at the same time rationalizing SKUs for slower-turning businesses and maintaining our inventory levels.

For us, we're very much focused on making sure that we've got the right parts in order to be able to say yes on a more frequent basis to our customers, and that's really been the primary emphasis. We've kept inventory relatively in check and on a net inventory basis we actually made progress there. If you're thinking about it from a capital perspective, we've actually utilized less capital in order to do that.

Bill Rhodes

There may be a little bit of confusion on the way we talk about inventory per store, which on a year-over-year basis, our inventory per store was $500,000 this year, $501,000 last year. However, we have reduced pay on scan inventory over time, so we've taken on the inventory ownership and gotten increased terms from our vendors. On the top line if you just look at owned inventory, that number is increasing, but overall deployed inventory is not.

Irene for Danielle Fox - Merrill Lynch

Just a follow up, can you talk a little bit more about why occupancy costs were up this quarter and if you expect that to continue going forward?

Bill Giles

We would always expect to have a little bit of pressure on occupancy costs and as we said before, we probably need about a 1.5% to 2% same-store sales in order to leverage SG&A, and that's obviously particularly on our fixed costs. We do see a little bit more increase as we continue to open new stores that we probably have a slightly higher percentage of leased stores versus purchased stores which generates a little bit higher from a rent perspective, but overall, our new stores are opening well and our productivity continues to be good.

Operator

Your next question comes from Peter Benedict - Wachovia.

Peter Benedict - Wachovia

Bill, the depreciation line has been growing mid-teens last several quarters. I think there was something with the lease accounting you're talking about maybe has been impacting that. Should we expect that growth rate to moderate as we look into next year?

Bill Giles

I think I would expect that to moderate from the standpoint you have capital leases, those leases converted into capital leases, and therefore you had an incremental hit a little bit if you will on the depreciation side just from an accounting standpoint, so as we anniversary that, I wouldn't expect to see that increase again.

Peter Benedict - Wachovia

On that AP ratio, 100%, any rough timeframe and where you think you might realistically be able to get there?

Bill Giles

We don't necessarily have a timeframe specifically identified for that. I think we made good progress this year. We believe we've put some pretty good tactics in place for next year as well, so we will continue to move towards that 100%, but we don't have a steadfast time period in which to achieve that.

Operator

Your next question comes from Tony Cristello - BB&T.

Tony Cristello - BB&T Capital Markets

Good morning, gentlemen. Bill, have you seen any change in buying patterns, or has there been any further deterioration in demand for the non-discretionary components either in the DIY or the commercial side of the business?

Bill Rhodes

I wouldn't say there were significant changes that weren't done by our actions. We've gone through product changes and planogram changes, and we've changed a few planograms that when we go into those changes sometimes we see deceleration, but I think that is self-inflicted versus anything macro-oriented.

Tony Cristello - BB&T Capital Markets

A follow-up on that question, over the past 12 to 18 months, the mindset there of the consumer has been one of deferral and gas prices and haven't really changed meaningfully this year to last year. If the macro were to tighten or get a little bit worse, do you think that would have a greater negative impact on the consumer or do you think your customers are already acting as if there was more of a recessionary environment with respect to automotive repair right now?

Bill Rhodes

Tony, we've modeled over long periods of time the impacts of macro economic changes to our performance, and quite frankly, we can't draw a very good correlation with that. What we continue to draw the correlation to is miles driven and the number of vehicles on the road and specifically those that are seven years old and older. I don't think we sit here today and say there is going to be a radical shift in what happens no matter what happens in the macro environment. Granted, the one correlation that we have made over the last three years is that there seems to be a negative correlation with miles driven as gas prices go up. That's the one that we've seen directly correlated.

Tony Cristello - BB&T Capital Markets

Well, the longevity of a vehicle typically results in more of the critical parts replacement and less concern about some of the more discretionary items and more difficult or challenging environment, wouldn't that bode well for the typical DIY business?

Bill Rhodes

It certainly seems to be the intuition, and that's certainly our bread and butter is the nondiscretionary part but I can't tell you factually that we can draw a correlation to it, and we've been through this business for 28 years and been through several economic cycles, and so I don't want to mislead you and say that I think the intuition is right, but I can't support it with facts.

Operator

We have a question from Seth Basham - Credit Suisse.

Seth Basham - Credit Suisse

I would like to dig a little bit deeper into the commercial efforts. Seems you made progress there but you are still sort short of your expectations this quarter in terms of the sales, if I am interpreting your comments correctly. Can you pinpoint where you're falling short? Is it on the lack of productivity from some of the investments you made in inventory, is it the sales culture not building as quickly as expected? Can you help us better understand that?

Bill Rhodes

Seth, based upon the plan that is we had to reevaluate really over the course of the last year, we really reevaluated the core operations in that business, and we might have been a little bit bullish on what we expected to do in light of the way we were approaching that. So I am very pleased with where we are. I am not satisfied with where we are, can't certainly be satisfied with a 0.5% increase in commercial, but I am more focused now on are we building the foundational support levels and are we beginning to build this world class sales force? I think we're making progress in both areas.

Now, we are not ones to go out there and do things radical or quick. We're going to make sure and test it, and as I mentioned before, we can go test something in 50 stores and make sure that it works so that we're not testing unproven ideas. That's the approach we've had and that's the approach we're going to continue to have.

Seth Basham - Credit Suisse

Are there certain categories of hard parts you've added that have not met your expectations and are you going to be pulling anything out of the stores going forward?

Bill Rhodes

Certainly. I would say that not on a category level, but as we go into the individual details, remember, we place products in our stores based upon a store to store basis, so each store behind the counter has a complete different set of parts, and so as we are getting into the first year of this new merchandise assortment tool, we're learning where we were dead on with our assumptions, and we're learning where we made some mistakes, so we'll continue to refine that. The changes will be less significant this year than they were last year, but they'll still be fairly significant.

Seth Basham - Credit Suisse

Just moving on a couple other quick questions, Bill, are you seeing any evidence that customers are trading down in terms of the quality of merchandise they're buying?

Bill Giles

Absolutely not.

Seth Basham - Credit Suisse

That's great. Going forward in 2008, I appreciate your comments on 1.5% to 2% expectation for leverage. Are you suggesting that you expect to leverage comps in 2008?

Bill Rhodes

That gets too close to guidance for us. We're just trying to make sure and ground everybody in what we think it takes and that hasn't changed significantly.

Before we conclude the call, I would like to take a moment to reiterate that we're excited about our growth prospects for the upcoming year. We understand we have to earn those sales every day. We have a solid game plan heading into 2008 and the best team in the industry to accomplish it. While we have an incredible business model built on a strong foundation of disciplined processes focused on delivering great customer service, we understand we cannot take anything for granted.

As we continue to focus on the basics and never take our eye off optimizing long-term shareholder value, we are confident we will continue to be incredibly successful. Thank you very much for participating in today's call. Have a great day.

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